SERIES 7 EXAM STUFY TIPS - SERIES 7 COVERED OPTION STRATEGY EXAMPLES - SERIES 7 HELP

Being able to understand and conceptualize Covered Call Options is important to do well on the Series 7 exam. 

The first point to understand is the underlying strategy. That strategy is normally to generate income from selling (or shorting or writing) the call option on a stock you own. Covered call writing is normally when a holder of the stock expects little to no movement or some modest downward price decrease where the income received by writing the call helps hedge the stock decrease. 

COVERED CALL EXAMPLE  

A person owns 100 Shares of DFR stock at a price of $90. The holder based on the stocks price history expects stability over the next 2 months. So if we mark the date as Feb 10th, the investor decides to Write (or short/sell) 1 DFR APR 95 CALL for a $500 premium. The premium is the income. 

Standard options expire monthly and call options get exercised or increase in value when the underlying stock increases. If the stock does not increase or at least does not hit 95, the option may expire worthless. The investor will keep the $500 premium. That is profit. If this is successful, the investor has also lowered his overall cost for the stock, which is now at $85 a share. 

Let's review the layout and see what the overall maximum gain, maximum loss and breakeven would be. 

BUY 1 DFR @90

SHORT 1 DFR 95 CALL@5

The breakeven is the cost layout per share of the stock and premium received, which is 85

The Maximum loss is the same as the breakeven point in total money spent, which is $8500. If the stock declines to zero (worthless), the option does not protect that potential stock loss, so the $9000 spent is all at risk. If we minus the $500 received, the maximum loss is clearly $8500. 

The Maximum gain also has to do with the stock profit potential. Always focus on the stock with stock and option pairings. The stock is where most of the money is invested and is the main position. The Stock is a hedge. 

The Maximum gain is the stock rising up until the strike price of the option. When you sell or write covered calls, you obligated to deliver (or sell) 100 shares of the stock at that strike price (95). So the difference in those prices is $500 (90 to 95) plus the $500 premium received which then equals $1000 

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